For the three months ended March 31, 2018, the high-yield market outperformed the investment-grade bond market. For example, the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Bond Index (BBC2%HYBI) returned -0.86% versus a -1.46% return for the Bloomberg Barclays Aggregate Bond Index (Aggregate), a measure of high-quality bond performance.

High-yield bonds outperformed the Aggregate for the ninth consecutive quarter although rising interest rates led to negative returns for both indexes. Strong global economic growth continued to be the dominant factor impacting markets. On the plus side for high yield, strong economic growth continued to support good credit fundamentals. Tax relief and strength on the jobs front were just a few of the factors leading to high business and consumer confidence. On the negative side, strong economic growth led to rising interest rates as investors contemplated a more active Federal Reserve (Fed) response to economic conditions. Volatility returned to risk markets as investors weighed strong global economic growth against already rich valuations, contemplated U.S. trade actions, and pondered potentially more increases in interest rates as the Fed slowly shifted its focus from stimulating growth to fighting inflation. Credit spreads moved modestly wider as trade concerns and volatility late in the quarter offset positive economic fundamentals. For example, the yield spread between the Credit Suisse High Yield Bond Index and Treasury securities with comparable maturities moved from 394 basis points to 401 basis points during the quarter.

Within the high-yield market, the strongest-performing major industries relative to the BBC2%HYBI were Wireline Telecommunications, Retail, Health Care, Aerospace/Defense and Media/Entertainment. The worst-performing major industries relative to the BBC2%HYBI were: Restaurants, Wireless Telecommunications, Banking, Automotive and Food & Beverage. From a quality perspective, the credit-sensitive CCC-rated sector led the way with a 0.30% total return followed by the B-rated sector, which returned -0.55%. The more interest-rate sensitive BB-rated sector was the worst-performing quality sector with a -1.60% total return.

Fund Performance

The following discussion relates to the fund’s Institutional Shares relative to the BBC2%HYBI. The fund underperformed the BBC2%HYBI mainly due to security selection. This was especially true in the Media/Entertainment, Wireless Telecommunication and Midstream sectors. While the fund was overweight the outperforming CCC-rated sector, the fund tended to be in lower-yielding securities within both the CCC-rated and B-rated quality sectors. In general, higher-yielding, riskier securities from a credit perspective tended to outperform during the quarter. The fund was also negatively impacted by its underweight to the strong-performing Wireline Telecommunication sector. Specific high-yield issuers held by the portfolio that negatively impacted performance relative to the BBC2%HYBI included: Anna Merger Sub (aka Acosta), Altice, Inception Merger Sub (aka Rackspace), Ultra Resources and Community Health Systems. The fund’s total return for the period also reflected actual cash flows, transaction costs and other expenses that were not reflected in the total return of the BBC2%HYBI.

Click on the Portfolio Characteristics tab for information on quality ratings and the fund’s top 10 holdings.

Outlook

We believe that the lows in credit spreads for this cycle are yet to come as economic expansion and strong corporate earnings will continue to support high-yield fundamentals. Volatility has returned to the markets and will most likely remain higher than in recent quarters as investors weigh strong economic conditions against rising interest rates and government policy actions. With spreads below historic medians, security selection will most likely be the primary driver of outperformance in the high-yield sector. At this point in the credit cycle, large (perhaps unwarranted) increases in credit risk may be necessary to achieve small performance gains. So while we believe the lows in credit spreads are yet to occur in this cycle, we believe prudent risk management is necessary for longer-term outperformance.

Key Investment Team

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